Don't Get Carried Away by Big Dividends

The old adage that if it's too good to be true, it probably is, still holds its value, especially with dividend-paying stocks, writes Marin Katusa of Casey Research.

My most recent trip to Calgary gave me a welcome chance to catch up with friends and colleagues in Cow Town's oil and gas sector. I found out about new projects, investigated companies of interest, and came away with an improved feel for the current state of affairs—what's hot, what's not, and why.

I also came away reminded of one of the dangers that lurk within troubled markets—and today's markets are troubled.

Since mid-March, North America's exchanges have struggled, with the Dow Jones losing all the momentum that had propelled a spectacular 17% gain over the previous five months while the Toronto Stock Exchange also sputtered and slid, turning downward to lose its slight gains from January and February. Fundamental economic problems remain unresolved in the United States and Europe, while uncertainty grows over China's ability to control inflation and maintain growth.

The outlook from here is not great. When markets turn bearish, investment strategies often turn toward income stocks, and rightly so: if market malaise is expected to keep share prices in check, dividends become a very good place to look for profits.

But whenever a particular characteristic—such as a good dividend yield—becomes desirable, it also becomes dangerous. The sad truth is that scammers and profiteers jump aboard the bandwagon, and start making offers that seem too good to refuse.

It was just such an offer that reminded me of this danger. In the question-and-answer period following my talk in Calgary at the Cambridge House Resource Conference, an audience member asked my opinion of a new, private company that was offering a 14.7% monthly dividend yield.

Yes, you read that right: a 14.7% monthly yield, from a new, private, natural gas company.

I had met with this company the previous day, and in that meeting the slick individuals who promised such glorious dividends got stumped by some pretty simple questions. When asked what the company's 12-month payout ratio was, the individual responded with, "Our working interest varies between 25% and 70%."

Perhaps he didn't hear my question, I thought, so I tried again. This time he stated that they pay a 14.7% dividend monthly...again, not answering the question. An interaction like this should set your spider senses tingling. A few questions later, it was obvious that they had no clue what they were talking about or trying to sell.

So, back to the very pleasant older man who asked the question at the end of my talk. My answer—which applies to almost everything in life—was this: if it sounds too good to be true, it probably is.

If Apple (AAPL), with highly robust cash flows and $98 billion in the bank, is only paying a 1.8% annual dividend, why would a small natural gas start-up be able to pay almost 40%? For a company to guarantee a return of that magnitude is completely ridiculous.

At the end of the talk, I responded to many questions, but the highlight of the show for me came when the nice old man who asked me about the 14.7% dividend came up with his sweet old wife. They wanted to shake my hand and thank me.

Those slick guys promoting that private stock had convinced this couple that the dividends from and return on this investment would solve their income issues in their retirement years, and they were ready to put down a fair chunk of cash. Thankfully, because I was quite open and vocal with my opinion that this private company was ridiculous fluff, the couple stayed away.

Ridiculous or not, those promises are out there. Unfortunately, promoters trying to cash in on investors' desires for the relatively security of dividends will promote these "deals" more and more as the market turns negative. It's just another unsavory characteristic of rough markets—preachers come out and make all kinds of impossible promises.

Thankfully, a few bad apples don't have to spoil the whole cart.

If you agree with the Casey-Research consensus that markets will remain volatile and generally negative over the next year, dividend stocks are a good way to get paid for taking on the risk of investing in a market that climbed notably through the winter without a lot of good reason.

If the market from here generally moves sideways, non-dividend stocks will leave your portfolio stuck in place. If you buy dividend payers and reinvest the gains for further dividends, you can still profit from a bear market.

In addition, data suggest that top dividend payers have a history of outperformance, both in the US and globally. It makes sense: only a company with good net earnings can sustain a good dividend, so the two go hand in hand.

But the companies I'm talking about here are huge corporations with established revenues and proven track records. Moreover, good dividends and strong performance are correlated—there is no causality. The fact that the top dividend payers often perform well cannot be taken to mean that paying a high dividend ensures that a company will outperform.

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For starters, take dividend yield. A company's dividend yield is its annual dividend payout divided by its share price. A high yield means big payouts relative to the costs of buying shares, so at first blush a high yield might seem like a good thing.

But be careful: when stock prices fall, dividend yields rise. That means some of the worst stocks out there offer some of the highest dividend yields. Of course, such stocks are value traps—trying to recoup your initial investment will be like trying to catch a falling knife, and the dividend payments you banked will be of little comfort for the cuts you get on the way.

Then there's the basic point that a high dividend does not mean much if a company cannot continue to pay it in the future. Cash flow and profits should give you an idea of whether there is enough money around to sustain the promised dividend. For a more informed look at that relationship, check out a company's quick ratio, which compares liquid assets and current liabilities.

Those bits of information are the tip of the iceberg when it comes to researching how to choose the best dividend-paying stocks for your portfolio. That is not my goal here today. My goal is to remind you that, in investing, vigilance is always key—and never more important than at the start of a downturn.

When things have been going well for a little while (or a long while), many investors stop asking the tough questions. Wanting to believe that the markets will keep climbing and the money taps keep flowing, they pretend downside risks don't matter.

A usually cautious investor might accept that a company with an early-stage uranium project in remote Mongolia can access the millions of dollars needed for a pre-feasibility study, assume the price of uranium will keep rising, and make a marginal deposit economic, or take a management team at its word that a project will receive regulatory approval.

(If a management team ever assures you of project approval before it has happened, be very careful—good management teams never put the cart before the horse, and permitting any resource project anywhere in the world is a lengthy and costly matter.)

And those assumptions often work out, but only as long as the bull market continues. As soon as Market stumbles, yesterday's assumptions become today's value traps.

Making matters worse, some promoters live to profit off investor mistakes, and are always looking to capitalize on shifts in the marketplace. If a slowing market generates a shift toward dividend-paying stocks, these profiteers will start promising double-digit dividend yields, representing an appealing combination of yesterday's easy-money attitude with today's "income please" perspective.

Traps like these are avoidable, but only if you get a handle on your greed. We all invest to make money, but greed—the desire to make lots of quick, easy money—will lead you into one value trap after another. Instead, you have to lead with your head.

Before buying a stock, make sure you know why you're buying it and what you plan to do with it. Is it a long-term hold, with a proven management team and a well-planned strategy? Is it a takeover candidate—and if so, who are the contending acquirers and what is the timeline? Or is it a quick flip, based on a rising commodity price or an area play?

In any scenario, do you have your exit mapped out? Is there enough liquidity to make a speedy exit?

Some scams and value traps are relatively easy to spot, such as the promise of a 14.7% monthly dividend. Others are much harder to avoid.

More generally, investing is complicated and fast-paced, and every decision carries the weight of your hard-earned dollars. It is much easier to bear that weight with help from an expert.